Why Japan's Economy Is In A Ditch -- And What Must Be Done To Pull It Out

“Japan Falls into Recession” is the lead headline in today’s business news, as the world’s third-largest economy shrank in the third quarter. The previous quarter had also seen the economy contract, but that downturn was spun as a temporary reaction to the government’s 60% increase in the national sales tax last spring. Temporary it was not.

The news about Japan is shocking to many because of the worldwide excitement generated not so long ago over Prime Minister Abe’s bold goal to dramatically end Japan’s 20 years of economic sluggishness. Instead, the economy is going in reverse.

There are two areas in which the Abe government must make big—and positive—changes, which would quickly garner the prime minister’s desired results.

--Monetary policy. The recent stunning announcement by the head of the Bank of Japan of a massive increase in the bank’s purchase of assets—mostly government bonds—is a nonstarter. Ice it. It will do more harm then good.

This is a version of the Federal Reserve’s now-ended quantitative easing (QE), which had the perverse result of slowing the U.S. economy. QE directed credit to the federal government and big companies, while starving small and new businesses—the big creators of new jobs—of needed credit. American households also saw the volume of credit shrink. This is a critical reason that the U.S. recovery from the sharp 2008–09 downturn has been so feeble. U.S. bank regulators made sure the increase in reserves didn’t translate into a vigorous increase in lending.

What the Bank of Japan should do is either fix a yen/U.S. dollar ratio or put a hard floor under the yen against the dollar, say at 120. Currency stability is critical for the kind of investments that enable an economy to grow. Contrary to what passes for wisdom these days, cheapening a currency never leads to sustained growth.

--Taxes. Japan is overtaxed. Other than that of the U.S., Japan’s corporate tax rate is the worst in the world. Slash it.

Japan’s payroll tax is also a horror: a combined employer/employee rate of almost 30%. Even worse, unlike the U.S.’ Social Security levy, Japan’s has no salary cap. Everything one earns on the job is hit by this ferocious exaction—and, worse, it’s slated to rise to 37% by 2017. At the least, these boosts should be stopped.

Japan’s personal income taxes are also exorbitant, with the top rate higher than 50%. Big cuts on the scale of those President Ronald Reagan made in the 1980s for the U.S. are in order.

One heartening sign in all this is that Prime Minister Abe is postponing next year's rise (yes, another) in the sales tax until 2017. But, assuming he wins the snap election he just called, he must go much, much further and push for big rate slashes on both the personal and business side. Abe will face fierce opposition from the powerful Ministry of Finance, which many years ago became strangely addicted to ever more and ever higher taxes.

Once upon a time—from the late 1940s to the 1970s—Japan was a paragon of spending prudence (today Japan’s government debt-to-GDP ratio is the worst in the developed world), low taxes and monetary virtue, which is why its economy grew at double-digit rates well after exceeding pre-war production levels.

Japan can again become a powerhouse of growth if it makes these tax and money changes.